Indexed Universal Life (IUL) vs. 401(k)

When creating your personal retirement plan, there are a variety of tools you can use to fund your long-term savings goals. An employer-sponsored 401(k) is one of them, and indexed universal life insurance (IUL) is another. There are notable differences when comparing IUL vs. a 401(k), though. A 401(k) allows you to invest money on a tax-deferred basis while also enjoying a tax deduction for contributions. Meanwhile, indexed universal life insurance allows you to secure a death benefit for your loved ones while accumulating cash value that you can borrow against.

A financial advisor can also help you use these vehicles to plan for your retirement.

What Is Indexed Universal Life Insurance?

Indexed universal life insurance is a type of permanent life insurance coverage. When you buy a policy, you’re covered for the rest of your natural life as long as your premiums are paid. When you pass away, the policy pays out a death benefit to your beneficiaries.

During your lifetime, an IUL insurance policy can accumulate cash value. Part of the premiums you pay are allocated to a cash-value account. That account tracks the performance of an underlying stock index, such as the Nasdaq or S&P 500 Composite Price Index. As the index moves up or down, the insurance company credits the cash value portion of your policy with interest. 

Cash value that accumulates inside an IUL insurance policy then grows tax-deferred. It is possible to borrow against the policy’s cash value if necessary. However, any loans left unpaid at the time you pass away are deducted from the death benefit.

IUL Caps, Floors and Participation Rates

A key element shaping the long-term performance of an indexed universal life policy is how the insurer credits interest to the cash value. Unlike investing directly in an index fund, where returns follow the market’s full movement, an IUL applies a series of contract terms that limit or filter how much of that market performance reaches your account. These terms drive most of the difference between the illustrated returns and the actual returns that policyholders experience.

Most IULs include a cap, which is the maximum credited rate in a given period. So, for instance, if an index rises 15% in a strong year but the contract cap is 6%, the credited interest will not exceed that ceiling. Participation rates further shape returns by determining what percentage of the index’s upside is used in crediting. A policy with a 70% participation rate would credit only 70% of the index gain, subject to the cap. Spread charges or asset-based fees can reduce the credited rate even when the index performs well, marking another downside of IUL.

Floors work in the opposite direction. They prevent the credited interest from falling below zero when the index declines. While floors protect cash value from market losses, they do not insulate the policy from rising internal costs over time. As mortality charges increase with age, a 0% floor does not guarantee that cash value will remain stable unless premiums are sufficient to support the policy.

Understanding these mechanics is essential because they are what determines the effective return of an IUL, not the raw performance of the underlying index. They also explain why long-term outcomes can diverge from retirement accounts built with direct exposure to stocks and bonds, where gains and losses flow through without crediting limits.

What Is a 401(k)?

A 401(k) is a type of qualified retirement plan that allows you to set money aside for retirement on a tax-advantaged basis. Contributions are deducted from your paychecks via an elective salary deferral, and your employer can also offer a matching contribution. For 2026, the contribution limit for employees is $24,500. Workers over the age of 50 can contribute an additional $8,000 per year. Additionally, those between the ages 60 and 63 are eligible for a super catch-up contribution limit of $11,250.

Employee and employer contributions grow tax-deferred and starting at age 59 ½, you can make penalty-free withdrawals. Any withdrawals made before age 59 ½ may be subject to a 10% early withdrawal penalty as well as income tax. Otherwise, tax treatment varies depending on the type of 401(k) you have.

Types of 401(k)s

• Traditional 401(k) contributions are made using pre-tax dollars. Any money you contribute is automatically deducted from your taxable income from the year. When you begin taking money out of your 401(k) in retirement, you’ll pay ordinary income tax on withdrawals. 
• A Roth 401(k), meanwhile, is funded with after-tax dollars, and qualified withdrawals are tax-free.

Both traditional and Roth 401(k) plans allow you to invest in a variety of securities, including mutual funds and ETFs. Target-date funds are also a popular option. These funds automatically adjust your asset allocation based on your target retirement date.

There’s no death benefit component with a 401(k). Rather, this is money you save during your working years that you can tap into in retirement. Unless you’re still working with the same employer, you must begin takingrequired minimum distributions (RMDs) from a 401(k) beginning at age 73 (or age 75 if you were born in 1960 or later).

Estimate your required withdrawals from a 401(k) or IRA using our free RMD calculator:

Failing to take the proper RMD can trigger a tax penalty equivalent to 25% of the amount you were required to withdraw (10% if fixed within two years). Your RMD in a given year is based on your account balance from December 31 of the previous year. For example, say you need to figure out how much you must withdraw from your 401(k) to satisfy your 2026 RMD. You’d need your account balance as of December 31, 2025.

You then divide the balance by the IRS distribution factor that corresponds with your age, which you can find on the IRS’s Uniform Lifetime Table.

IUL vs. 401(k): Which Is Better for Retirement Savings?

Indexed universal life insurance and 401(k) plans can both be used as investment tools for retirement. But there are some important differences to note. 

With IUL, returns are tied to the performance of an underlying index. If the index performs well, then your policy earns a higher interest rate. If the index underperforms, on the other hand, your returns may shrink. Your insurance company can also cap the rate of return that’s credited to your account each year, regardless of how well the underlying index does. For example, you may have a cap rate of 3% or 4% annually.

In a 401(k) plan, you have the option to invest in index mutual funds or ETFs, but you’re not locked into just those investments. You can also choose actively managed funds, target-date funds and other securities, based on your time frame for investing, goals and risk tolerance. Your rate of return is still tied to how well those investments perform, but there’s no cap. So, if you invest in an index fund that goes up by 20%, you’ll see that reflected in your 401(k) balance.

A 401(k) also offers the advantage of an employer-matching contribution. This is essentially free money that you can use to grow retirement wealth. With an indexed universal life insurance policy, you’re responsible for paying all of the premium costs.

IUL vs 401k: Tax Treatment and Withdrawals

Another big difference between the two centers on tax treatment and withdrawals. With an indexed universal life insurance policy, you can borrow against the cash value at any time. You’ll pay no capital gains tax on loans and no penalties unless you surrender the policy completely or fail to repay what you borrow. Death benefits pass to your beneficiaries tax-free.

With a 401(k), you could technically take money out of your plan early for a hardship withdrawal or some other reason, but a 10% early withdrawal penalty may apply. The IRS allows some exceptions to this rule, though.

The rule of 55 also allows for penalty-free withdrawals from 401(k) plans. This rule allows you to withdraw money from your 401(k) without the added penalty if the withdrawal occurs in the year that you turn 55 and only if you separate from your employer. You cannot use this rule to make penalty-free withdrawals from an old 401(k) with a previous employer.

With any penalty-free withdrawals from a traditional 401(k), you’d still owe income tax on the distribution. You could take out a 401(k) loan instead, but that also has tax implications. If you separate from your employer with an outstanding loan balance and fail to repay the loan in full, the entire amount can be treated as a taxable distribution.

Qualified distributions in retirement are taxable at your regular income tax rate. If you pass away with a balance in your 401(k), the beneficiary who inherits the money will have to pay taxes on it. 

When to Consider IUL as a Supplement to a 401(k)

A 401(k) is often the foundation of a retirement savings plan due to the tax-deferred growth it offers, the possibility of employer matching and high annual contribution limits. However, indexed universal life insurance can serve as a secondary tool in specific situations. It may offer added flexibility, insurance protection and tax-efficient withdrawals that traditional retirement accounts do not provide.

Here are some scenarios in which you might consider adding IUL:

• You’ve maxed out retirement account contributions. If you are already contributing the maximum to your 401(k) and IRA and still want to save more in a tax-advantaged vehicle, an IUL can provide additional room for tax-deferred growth. Unlike retirement plans, there is no IRS-imposed annual limit on how much premium you can contribute, subject to policy guidelines.
• You’re looking for income tax diversification. A 401(k) produces taxable income in retirement, with distributions taxed at ordinary income rates. In contrast, loans from an IUL policy are generally tax-free if managed properly. Using both accounts together allows retirees to blend taxable and non-taxable income sources. This may help reduce their overall tax burden and manage marginal tax brackets.
• You may need early access to funds. A 401(k) limits access before age 59 ½, and early withdrawals may trigger penalties and taxes. An IUL does not have this restriction. Policy loans can be taken at any time without triggering taxes, provided the policy remains in force and is not surrendered. This feature may be useful for early retirees, self-employed individuals or those expecting variable income.
• You are looking into legacy planning. A 401(k) has no built-in death benefit. Beneficiaries who inherit a 401(k) will owe taxes on withdrawals. An IUL includes a life insurance component, which pays a generally income-tax-free death benefit. This can support estate planning or create liquidity for heirs.
• You want an option without RMDs. A 401(k) requires that you take minimum distributions starting at age 73. An IUL has no such requirement. Policyholders can choose whether and when to access the cash value, which adds flexibility in managing withdrawals and taxes during retirement.

Potential Drawbacks

There are some potential drawbacks with IUL to keep in mind, however.

Despite the benefits, IUL policies come with costs: Administrative fees, mortality charges, and surrender penalties can reduce returns. Further, the growth of the cash value is subject to index caps and participation rates. If premiums are not maintained or loans are mismanaged, the policy could lapse, triggering tax consequences and loss of coverage.

Ultimately, an IUL should generally not replace a 401(k). However, it may be used to complement one—particularly for high earners, those with strong cash flow or individuals seeking insurance-based tax strategies alongside their retirement plan.

Bottom Line

Indexed universal life insurance and a 401(k) plan can both help you build wealth for retirement, but they serve different purposes in your financial plan. If you have a 401(k) at work, this may be the first place to start when creating a retirement savings plan. You can then decide if IUL or another type of life insurance is needed. It could supplement your workplace savings, as well as the money you’re investing in an IRA or brokerage account.

Retirement Planning Tips

• Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Use SmartAsset’s retirement calculator to get a sense of if you’re on track to be ready.

SmartAsset follows a rigorous and detailed Editorial Policy, that covers principles surrounding accuracy, trustworthiness, editorial independence, expertise and objectivity.

Photo credit: ©iStock.com/yongyuan, ©iStock.com/kupicoo, ©iStock.com/Piotrekswat